Both are thoughtful, and as much as Waldman has the stronger argument, I suspect he will not be proven correct, at least near term.

Central bankers know in overlevered economies to break glass and print money. Bernanke has written at length as to how damaging even modest deflation is to borrowers and how it impedes investment and growth. He has famously observed that a determined central bank can always reflate, and hews to the conventional wisdom that Japan is in the mess it’s in due to not cutting rates fast enough when the bubble economy started imploding.

Yet I have a sneaking suspicion both Shedlock and Waldman will be proven right, that we will get a dose of deflation before the Fed turns on the printing press and debases the dollar (that was one of the consequences of the 1934 reflation).

Why? The Fed has been making bad judgment calls for some time that nevertheless get applauded, so they have little reason to question their moves to date. They have tended to wait too long to act, then move in too extreme a fashion. Bermanke & Co. were famously slow to recognize the severity of the subprime crisis. They suffer from what Willem Buiter calls “cognitive regulatory capture” in that they identify too strongly with the viewpoint of banks and Wall Street, that is, they lack sufficient detachment. They also suffer from a lack of expertise in the areas that are the epicenter of the crisis, such as securitized credits and credit default swaps. With all due respect to Timothy Geithner, the head of the New York Fed, no matter how much he talks to and trades with investment banks and broker/dealers, he and his colleagues cannot possibly have the same understanding of their business as they do of banks they supervise. (Worse, even the management of the investment banks may not fully understand what is up at their firms, as Michael Lewis has suggested. He contends that the products have gotten so complicated that only product experts can understand them, and top management doesn’t have the in-depth knowledge needed).

So the Fed cut too far, too fast. 75 became the new 25. And as Caroline Baum has noted, if the Fed knew it was going to create its alphabet soup of facilities, it wouldn’t have cut as deeply as it has. But it cannot undo the past.

But now the Fed is talking hawkishly (and maybe it hopes the hawkish talk will obviate the need to do anything). But if the Fed was with Waldman’s program, it would be thinking about cutting, or at least not raising rates.

Even though the Fed is supposed to be independent, it has been annexed by the Treasury department. Waldman argues that the national interest will be served by devaluation because deflation hurts workers, since the real value of their debt rises. As noted earlier, Bernanke is acutely aware of this issue.

But what he misses in his political calculus is how high commodity prices have put the Fed on tilt. More dollar weakness, even with a faltering global economy, presumably means at least somewhat more costly basic materials. Those are highly visible to consumer/voters. Higher real cost of debt, on the other hand, is far less obvious and plays out over time.

So I suspect the policy bias will continue to be to avoid debasing the dollar (unless we get a real price break and oil goes to $75 or lower, which would give the Fed much more latitude) until we start seeing second-order effects from deflationary trends, such as higher consumer defaults and heightened stress in the financial system.

But no matter how you slice it, the average worker is going to see his standard of living fall

Originally published at naked capitalism and reproduced here with the author’s permission.